Comparing competitors - Part 3

Four years ago we calculated some basic financial ratios for two competitors. One came out way ahead. Does the share price performance since then reflect well on the value of those ratios, and what can we learn from the exercise?

What makes a good business? It’s a question that’s hard to answer without resorting to investing boilerplate; strong financial position, excellent management and an enduring competitive advantage. But these soft, qualitative factors should show up in altogether more meaningful phrases; higher profit margins, higher return on equity and asset numbers, and lower debt ratios than competitors. And those, in turn, should deliver greater than average share price growth over the years.

That’s the theory anyway. In Part 1 and Part 2 we put this theory to the test. Comparing two plumbing supplies companies, Reece Holdings and Crane Group, over the period 1999 to 2003, Reece emerged the clear winner. But how reliable was the original analysis as a guide to future share price performance? Four years on and we have a pretty good idea.

Reece still ahead

Take a look at the revenue line in the (big) table below (to see how we’ve calculated the ratios, download an Excel spreadsheet from the Special Reports/General Reports section of the website). It’s clear that Reece – already in front in 2003 – has pulled even further away. While Reece grew revenue by 76% between 2003 and 2007, Crane eked out a mere 14% increase. The difference in profitability is starker still – Reece’s earnings before interest and tax (EBIT) had risen 123% over the same period; Crane’s EBIT had declined 10%.

Unsurprisingly, Reece’s financial ratios also improved. EBIT margins increased substantially between 2003 and 2007, as did return on assets and return on equity figures, while Crane’s margins and return ratios actually deteriorated.

With a net debt-to-equity ratio of -4.3%, Reece still has more cash than debt but is now using debt for working capital purposes. Based on the 2007 annual interest expense, we’d estimate Reece’s average debt over the 2007 year at about $20m compared with the $5m it owed on 30 June.

Crane’s net debt-to-equity ratio is the only one of its financial ratios to have improved – from 57.5% in 2003 to 40.9% in 2007, although its absolute debt hasn’t declined much. Instead, the slow-but-steady increase in equity (thanks in large part to a dilutionary dividend reinvestment plan) has helped ‘improve’ the situation. Reece, however, has the same number of shares on issue as it did in 1999.

Average performance

With Reece’s earnings per share more than doubling while Crane’s has fallen 18%, it’s no surprise to see its stock rising 235% since 2003 (sporting a PER of 27). What is surprising is that, despite a poor financial performance, Crane’s share price has actually increased, up 84%, (on a PER of 24). Obviously, ratios don’t explain everything.

What can we learn from this comparison? First, that margins matter. A management team that keeps costs low acquires an advantage. For every dollar of revenue, Reece now keeps 11.5 cents as operating profit. Its competitor, Crane’s Tradelink plumbing supplies division, keeps just 2.8 cents.

Third, the additional cash generated means growth can be funded without the use of debt. Reece’s store opening program was funded almost entirely from its own operations. Crane’s low margins mean it requires help from the bank to finance expansion. And that, as many companies are currently learning, entails risk.

Bigger houses, bigger bathrooms

Fourth, successful businesses exploit niche markets. Crane’s Tradelink division supplies plumbing items to tradesmen and that’s about it. Reece saw the trend for larger houses with big, luxurious bathrooms and developed retail showrooms where consumers could get ideas [while still fully clothed—Ed]. It gave the business a new growth leg and improved brand awareness.

All these factors spring from one driving force – management quality. And in our view there’s a link between the owner-managers in charge at Reece (the Wilson family owns 68% of the stock) and the lack of them at Crane (see Backing the best business leaders).

A final lesson: Once a company has an entrenched leadership position it can be very hard to displace. Reece’s focused approach, high margins and store opening program allow it to keep reinvesting in lower prices. Try as it might, with ‘strategies for cost base reduction, business simplification and network growth’, Crane is now running to stand still.

Deciding what to pay

Identifying a good business is easy. Deciding what to pay for it is harder. We’ve never officially covered Reece, partly because it always looked a little expensive. In hindsight, we underestimated the business’s likely future growth because we’ve not understood it well enough. In time, we plan on fixing that. As for Crane, we happily ceased coverage of it in 2006. We’d rather focus our attention on quality businesses, or at least companies that are good value. At the current price, it fits neither category.

We hope this series has highlighted a little of the analytical process. Analysing businesses requires a sense of perspective and looking at how a business and its competitors change over time is almost always enlightening.

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